Should you invest in cryptocurrency?

Should you invest in cryptocurrency?

It’s no wonder bitcoin and other cryptocurrency have captured the attention of investors around the world: if you invested $1,000 in bitcoin in 2010, it would be worth $287.5 million today. But crypto is frighteningly volatile, and should be approached with clarity and caution. Here’s what you need to know.

How much is bitcoin worth? Should you invest in it? If so, how do you invest in bitcoin? Great questions. And since its creation in 2009, bitcoin investing has intrigued, excited and, often, frightened market-watchers and investors alike. Notoriously volatile, the cryptocurrency traded at 8 cents per coin in 2010, to an all-time high of more than US$23,000 on Dec. 16, 2020. If you were to chart bitcoin’s worth in the intervening years, it would look like the profile of a terrifying roller coaster, with a long, slow, initial rise, followed by jagged peaks and valleys from 2017—the first time it crested US$20,000—to today.

There are other crypto investments, but bitcoin is considered the most widely traded and most successful. It has been mused that if you invested $1,000 in bitcoin at 8 cents per coin in 2010, your cryptocurrency investment would be worth $287.5 million today. Phew! No wonder bitcoin has captured so much interest.

What is bitcoin?
Bitcoin is a digital currency that many call the best cryptocurrency to buy, dubbing it “the new gold.” Of course, gold is one of the oldest currencies on earth, and currencies and methods of payment are always evolving.

What does this mean? Arthur Salzer of Northland Wealth Management offers: “Monetary value usually arises from objects that are scarce, durable and relatively easy to divide. Since the dawn of civilization, societies have used rare seashells, wampum, glass beads, and stones as money or a form of record keeping. Gold is an ideal example since it can be made into jewelry, coins and bars, but bitcoin is unique in today’s digital world since it is scarce, durable, has strong privacy characteristics.”

These days, gold is rarely used as a form of payment; it’s seen more as a store of value, and an investment or portfolio asset that is not highly correlated to stocks and bonds and cash.

Similarly, supporters and owners of cryptocurrency invest in bitcoin because they see it as a store of value, and a useful portfolio asset. Bitcoin may also work its way into a direct method of payment as well. In other words, you might one day use bitcoin to buy a car or a loaf of bread. It’s a lot quicker and easier to send digital money than to lug around bars of gold.

How to invest in cryptocurency
Bitcoin isn’t your typical investment. In fact, as a digital currency, bitcoin is not a physical coin. Rather, a bitcoin is created and then accessed by way of a digital code. This happens over the internet.

The ledger (blockchain) where the transactions are executed and monitored is public and for all to see. That’s referred to as “open source.”

The creator of bitcoin, who goes by the pseudonym Satoshi Nakamoto, describes bitcoin as “a purely peer-to-peer version of electronic cash that allows online payments to be sent directly from one party to another without going through a financial institution.”

In essence, bitcoin is a public ledger shared by a network of computers. To pay with or to exchange bitcoins, you send a signed message transferring ownership to a receiver’s public key. Each bitcoin is locked by a second private key. Think of a private key as a more complicated series of passwords called a “seed.” No one can access any amount of bitcoin without a private key. Obviously, it is crucial that you keep track of both the public and private keys, and do not share those keys except with a person you trust as your backup. If you lose your keys, you lose your bitcoin.

Blockchain is the revolutionary record-keeping technology that is the backbone of bitcoin. No single person or group has control of the currency; all users are in control collectively. The larger the bitcoin network gets, the more secure it gets. The computer hubs (called nodes) all over the world are all continually fact-checking each other’s ledgers. Each translation is scrutinized. When bitcoin is exchanged, it’s as if millions of tellers are simultaneously confirming the validity of the translation.

How much is bitcoin worth?
How much is one bitcoin worth? Well, it depends on the day. Bitcoin has value because enough people believe bitcoin has value. That may be no different than gold. Gold is really just a shiny rock; but because it was “decided” centuries ago that gold was desirable (and scarce), it is considered a store of value. It became a currency and also a store of wealth, and a portfolio asset in modern times.

While no one knows with any certainty how much gold might be discovered, the algorithm for bitcoin release is capped at 21 million coins. To date, just over 18.5 million bitcoins have been created, and there are almost 2.4 million coins left to be released. Currently, 900 coins are released each day, and the last bitcoins will be released around 2040. Bitcoin “miners” (a.k.a. programmers) are rewarded with the new bitcoins, in payment for their verifications of the transaction on the blockchain.

It is the scarcity of bitcoin, and its finite quantity, that offer the greatest appeal to those who reject or question the value of fiat currencies such as the US dollar, the euro or the Canadian dollar. Certainly, bitcoin, as well as fiat currencies, are created “out of thin air.” But while central banks can create as much new currency as they see fit, there is a hard limit to the amount of bitcoin. That’s why those who favour bitcoin often call it “the hardest currency on earth.”

On the other side of the ledger, critics will offer that bitcoin is worthless because it is created out of thin air, and only backed by those who accept and exchange bitcoin, and assign value. In contrast, fiat currencies are backed by the wealth creation and taxing powers of each nation.

How is bitcoin mined, exactly?
Programmers (bitcoin miners) have to locate the new coins and then perform a series of complex mathematical equations in order to unlock the new coins. These miners collectively are also required to confirm ongoing bitcoin transitions verifying the details. As noted above, millions of digital eyeballs are on each transaction. But in the end, only one miner or miner group (called a “node”) will be rewarded with the new issue of bitcoins.

The successful miner “walks away” with the new coins, and the group of confirmed and verified bitcoin transactions (the “block”) is added to the existing record (“chain”) of transitions. That is how we get to the name and technology known as the “blockchain.”

You might think of these miners as paid auditors.

Other desirable attributes of bitcoin investing
Bitcoin is decentralized. It is not regulated by any government or any financial regulator. As you’ve read, bitcoin is operated and ‘policed’ by its own community. This decentralization is one of the greatest appeals for many who have embraced bitcoin.

As you may know, governments around the world have confiscated gold in the past and, during some periods, private ownership of gold was outlawed. However, in theory, government agencies will not be able to confiscate your bitcoin.

Bitcoin is portable, and near frictionless to send and receive. It can be sent from anywhere to anywhere in just seconds. It knows no borders.

The potential for bitcoin investors
Bitcoin has delivered mind-boggling returns from its inception. If you consider it an asset or an asset class, it has been the best-performing for many periods over the last 10 years. The following table takes us to the end of November 2020. Bitcoin then went on to add another 50% in December of 2020.

Despite the jaw-dropping overall gains over time, bitcoin is incredibly explosive and incredibly volatile. To come up a winner, one would have to be prepared for some violent moves to the downside.

And given the volatility and explosive characteristics, bitcoin historically has made a wonderful portfolio asset. How’s that? There is very little (or negative) correlation between bitcoin and other major assets. That’s exactly what we’re looking for when we seek portfolio diversification. We want non-correlated assets that will move in opposite directions.

Keep in mind though, that because bitcoin is still very volatile and explosive at its core, it will increase the overall volatility of a balanced portfolio. But historically it has boosted returns (although it’s important to remember that past performance is not a guarantee of future returns).

As CoinShares offers, using a 4% weighting in a balanced portfolio increased returns from 9.3% to 18.8%. The calculation is a 5-year period to the end of October 2020 (although it’s important to remember that past performance does not guarantee future returns).

As well, looking at the period from January of 2014 to the end of October 2020, an allocation of bitcoin would have contributed positively to a diversified portfolio’s cumulative and risk-adjusted returns in 74% of one-year periods, 97% of two-year periods, and 100% of three-year periods since 2014, assuming quarterly rebalancing.

How widely accepted is bitcoin today?
In July 2020, Michael Saylor, the billionaire founder of MicroStrategy, an American corporation that offers software-based solutions to client companies, directed his company to hold part of its cash reserves in alternative assets. By September, MicroStrategy’s corporate treasury had purchased bitcoins worth $425 million. Square, the San Francisco-based payments company, bought bitcoins worth $50 million in October 2020. More recently PayPal announced that American users can buy bitcoins, as well as hold and sell it in their PayPal wallets. Every week we see more major financial institutions “come on board.”

How do you buy bitcoin and hold cyrptocurrency?
Like paper money, you hold bitcoin in a wallet. In this case, it is a digital wallet. And “wallet” is a misnomer; the wallet doesn’t secure your bitcoin, but, rather, storing your keys—digital code that is required to unlock your bitcoin investment. No one, not even you, can access your bitcoin without your keys.

You can hold your bitcoin in a “hot wallet” or a “cold wallet.” Hot wallets are digital wallets stored online, whereas cold storage or cold wallets are most often physical hardware devices. As you might guess, cold storage is the gold standard for securing bitcoin keys; money held in a hot wallet might be as secure as a physical leather wallet—it could be stolen.

A cold wallet, which costs upwards of $150, offers physical bitcoin storage and is more secure, like a vault at a bank. Technically, your cold storage cannot be hacked as it is not accessible online. Think of it like a vault at the bank. Of course, you would have to take great care to ensure that you understand the technology and processes for storing your personal keys in a cold wallet.

What bitcoin options are available in Canada?
With the following options you will not have to own or create your own wallet, and becoming a bitcoin investor is as easy as opening an account and pressing a few buttons to buy or sell bitcoin. These companies will hold and store your keys on your behalf. As with buying mutual funds or ETFs there are fees for these services.

You can buy bitcoin, as well as sell it, with Wealthsmiple; the setup process is very quick and simple.

The same level of ease goes with the all-in-one solution at bitbuy.

You can also purchase closed end mutual funds from 3iQ and from CI Galaxy. These bitcoin funds are available in U.S. or Canadian dollars. An added bonus with these funds is that you can hold them in registered accounts such as an RRSP, RRIF, or even a TFSA. (Given the potential of explosive gains, a tax-free savings account would be a wonderful place to have exposure to bitcoin.)

If you’re wondering how to invest in bitcoin outside of your TFSA, you might also consider Grayscale, which is a U.S.-dollar fund.

What are the risks of owning bitcoin?
The greatest risk is the hacking of bitcoin exchange platforms and the bitcoin blockchain platform. To date, the bitcoin platform has never suffered a serious hacking event, but certainly many third party exchanges that hold bitcoin for their clients have been hacked, and bitcoin has been stolen.

In Canada, many were victims of the QuadrigaCX debacle. A total of 76,319 unsecured creditors—virtually all of them QuadrigaCX clients—have come forward to claim they are owed $214.6 million collectively. In the case of QuadrigaCX, the founder died and allegedly took the keys to his deathbed.

There are many other risks, including from governments that may attempt to circumvent or regulate this new currency, which is in competition with their own fiat currencies.

The ownership of bitcoin might also be concentrated in too few names, who can then control or manipulate the bitcoin price.

For a full rundown on the risks. you might check out the prospectus for the 3iQ bitcoin fund.

Is bitcoin safe, and more final thoughts on bitcoin
Bitcoin is an incredibly volatile but explosive asset. That’s why you might not need an aggressive allocation for bitcoin to have a considerable impact on your portfolio.

And given that bitcoin is (likely) near all-time highs at the time of this post’s initial publication in January 2021, you might simply dollar-cost-average into your position. You might be offered lower prices in the future. But if bitcoin keeps (mostly) rising, then you’re making money on the way up. That’s not a bad deal, either. If you’re interested in going deep into bitcoin, have a read of The Bitcoin Standard from Saifedean Ammous.

Given its explosive nature, you might develop an exit or rebalancing plan as well. I invested at a weight of 2% with plans to add more. But the recent surge in bitcoin price quickly took me to over a 6% weighting. I may trim the bitcoin holding when it reaches a 15% weighting, reducing it to 10%. When or if it moves to 15% again, trim back to 10%. Rinse and repeat. My risk is managed, as I am then in a very positive position at the very first trimming—even if I were to lose the remaining position. (Disclosure: I have invested in bitcoin by way of the 3iQ funds.)

For me, it was a no-brainer risk-return proposition, but you will have to decide for yourself.

This post is not a recommendation for bitcoin or crypto investment advice. If you decide to invest, please ensure that you understand the risks, and the risk of permanent loss.